Inflation/Deflation

Highlights We always strive to develop new analytical methods to complement our focus on judging currencies based on global liquidity conditions and the business cycle. This week, we introduce a ranking method based strictly on domestic factors: We call it the Aggregate Domestic Attractiveness Ranking. Using this method alone, the USD, the NZD, the AUD, and the NOK are the most attractive currencies over the coming three months, while the JPY, the GBP, the EUR and the CHF are the least attractive ones. If we further filter the results using a valuation gauge, the USD, the NOK and the CAD are the most attractive currencies over the coming three months, while the CHF, the JPY and the GBP are the least attractive ones. Ultimately, the message is clear: if the dollar corrects, domestic factors suggest it will be shallow. However, buying pro-cyclical commodity currencies at the expense of countercyclical ones makes sense no matter what. Feature This publication places significant emphasis on understanding where we stand in the global liquidity and business cycle in order to make forecasts for G-10 currencies. However, we also like to refer to other methods to add supplementary dimensions to our judgment calls. In this optic, we have focused on factor-based analyses such as understanding momentum, carry and valuation considerations. This week, we take another approach: We build a ranking methodology using domestic economic variables only, intentionally excluding global business cycle factors. Essentially, we want to create an additional filter to be used independently of our main method. This way, we can develop a true complement to our philosophy rooted in understanding the global business cycle. With this approach, we rank currencies in terms of domestic growth, slack, inflation, financial conditions, central bank monitors, and real rates. We look at the level of these variables as well as how they have evolved over the past 12 months. After ranking each currency for each criterion, we compute an aggregate attractiveness ranking incorporating all the information. We then compare the attractiveness of each currency to their premiums/discounts to our Intermediate-Term Timing Models. Based on this methodology, the USD, the NOK and the CAD are the most attractive currencies over the coming three months, while the CHF, the JPY, and the GBP are the least attractive ones. Building A Domestic Attractiveness Ranking Domestic Growth Chart I-1 Chart I-2 The first dimension tries to capture the strength and direction of domestic growth. We begin by looking at the annual growth rate of industrial production excluding construction, as well as how this growth rate has evolved over the past 12 months. Here, the currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. As Chart I-1 illustrates, Sweden is performing particularly well on this dimension, while the euro area, Switzerland, the U.K, and Japan are not. The U.S. stands toward the middle of the pack. When aggregating this dimension on both the first and second derivative of industrial production, Sweden ranks first, followed by the U.S. and Norway (Chart I-2). The U.K. and the euro area rank at the bottom. Chart I-3 Chart I-4 When trying to gauge the impact of domestic growth on each currency’s attractiveness, we also look at the forward-looking OECD leading economic indicator (LEI). As with industrial production, the currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. This changes the ranking. New Zealand exhibits the highest annual growth rate, followed by the U.S. Meanwhile, when looking at how the annual rate of change has evolved over the past 12 months, Australia shows the least deterioration, and the euro area the most (Chart I-3). Putting these two facets of the LEI together, Australia currently ranks first, followed by the U.S. and New Zealand. Switzerland and the U.K perform the most poorly (Chart I-4). Slack Chart I-5 Chart I-6 Then, we focus on slack, observing the dynamics in the unemployment gap, calculated using the OECD estimates of the non-accelerating inflation rate of unemployment (NAIRU). Here, the currencies of countries at the top right of the chart are least attractive, while those at the bottom left are most attractive. Switzerland enjoys both a very negative and rapidly falling unemployment gap (Chart I-5). The U.K. also exhibits a clear absence of slack, but in response to the woes surrounding Brexit, this tightness is decreasing. Interestingly, the euro area looks good. Despite its high unemployment rate of 7.9%, the unemployment gap is negative, a reflection of its high NAIRU. Combining the amount of slack with the change in slack, Switzerland, New Zealand and the euro area display the best rankings, while the U.S. and Sweden exhibit the worst (Chart I-6). The poor rankings for both the U.S. and Sweden reflect that there is little room for improvement in these countries. Inflation Chart I-7 Chart I-8 When ranking currencies on the inflation dimension, we look at core inflation and wages. We assume that rising inflationary pressures are a plus, as they indicate the need for tighter policy. We begin with core inflation itself; the currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. Canada and the U.S. both sport higher core inflation than the rest of the sample, as well positive inflationary momentum (Chart I-7). Switzerland displays both a very low level of inflation as well as declining momentum. U.K. inflation displays the least amount of momentum. On the core CPI ranking, the Canadian dollar ranks first, followed by the USD. Unsurprisingly, Japan and Switzerland rank at the bottom of the heap (Chart I-8). Chart I-9 Chart I-10   We also use wages to track inflationary conditions as G-10 central banks have put a lot of emphasis on labor costs. Similar to core inflation, we measure each country’s level of wage growth as well as its wage-growth momentum. The currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. This time, the U.S. and the U.K. display both the highest annual growth rate of wages as well as the fastest increase in wage inflation (Chart I-9). Meanwhile, Norwegian wage growth is very poor, but improving. The U.S. and the U.K. rank first on this dimension, while Switzerland and Canada rank last, the latter is impacted by its very sharp deceleration in wage growth (Chart I-10). Financial Conditions Chart I-11 Chart I-12 The Financial Conditions Index (FCI) has ample explanatory power when it comes to forecasting a country’s future growth and inflation prospects. This property has made the FCI a key variable tracked by G-10 central banks. Here we plot the level of the FCI relative to the annual change in FCI. A low and easing FCI boosts a nation’s growth prospects, while a high and tightening FCI hurts the outlook. Consequently, the currencies of countries at the top right of the chart are least attractive, while those at the bottom left are most attractive. While Switzerland has the highest level of FCI – courtesy of an overvalued exchange rate – the U.S. has experienced the greatest tightening in financial conditions (Chart I-11). Combining the level and change in FCI, we find that New Zealand currently possess the most pro-growth conditions, followed by both Sweden and Norway. On the other end of the spectrum, Japan and the U.S. suffer from the most deleterious financial backdrop (Chart I-12). Central Bank Monitors Chart I-13   Chart I-14 We often use the Central Bank Monitors devised by our Global Fixed Income Strategy sister publication as a gauge to evaluate the most probable next moves by central banks. It therefore makes great sense to use this tool in the current exercise. The only problem is that we currently do not have a Central Bank Monitor for Switzerland, Sweden and Norway. Nonetheless, using this variable to create a dimension, we compare where each available Central Bank Monitor stands with its evolution over the past 12 months. The currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. Currently, Canada and the U.S. show a clear need for tighter policy, without a pronounced fall in their respective Central Bank Monitors (Chart I-13). However, while the U.K. could stand higher rates right now, the British Central Bank Monitor is quickly falling, suggesting the window of opportunity for the Bank of England is dissipating fast. The euro area and Australia do not seem to justify higher rates right now. On this metric, Canada and the U.S. stand at one and two, while Australia and the euro area offer the least attractive conditions for their currencies (Chart I-14). Real Interest Rates Chart I-15 Chart I-16   The Uncovered Interest Rate Parity (UIP) hypothesis has been one the workhorses of modern finance in terms of forecasting exchange rates. To conduct this type of exercise, our previous work has often relied on a combination of short- and long-term real rates, a formulation with a good empirical track record.1 Accordingly, in the current exercise, we use this same combination of short- and long-term real rates to evaluate the attractiveness of G-10 currencies. This dimension is created by comparing the level of real rates to the change in real rates over the past 12 months. The currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. The U.S. dollar is buoyed by elevated and rising real rates, while the pound is hampered by low and falling real rates (Chart I-15). This results in the dollar ranking first on this dimension, and the pound ranking last (Chart I-16). Interestingly, the yen ranks second because depressed inflation expectations result in higher-than-average and rising real rates. Aggregate Domestic Attractiveness Ranking and Investment Conclusions Chart I-17 Chart I-18   Once we have ranked each currency on each dimension, we can compute the Aggregate Domestic Attractiveness Ranking as a simple average of the ranking of the eight different dimensions. Based on this method, domestic fundamentals suggest that the USD, the NZD, the NOK and the AUD are the most attractive currencies over the next three months or so, while the JPY, the GBP, the EUR and the CHF are the least attractive ones (Chart I-17). Interestingly, this confirms our current tactical recommendation espoused over recent weeks to favor pro-cyclical currencies at the expense of defensive currencies. However, it goes against our view that the U.S. dollar is likely to correct further over the same time frame. This difference reflects the fact that unlike our regular analysis, the Aggregate Domestic Attractiveness Ranking does not take into account the global business cycle, momentum and sentiment. We can refine this approach further and incorporate valuation considerations. We often rely on our Intermediate-Term Timing Model to gauge if a currency is cheap or not. Chart I-18 compares the Aggregate Domestic Attractiveness Ranking of G-10 currencies to their deviation from their ITTM. Countries at the bottom left offer the most attractive currencies, while those at the upper right are the least attractive currencies. This chart further emphasizes the attractiveness of the dollar: not only do domestic factors support the greenback, so do its short-term valuations. The CAD, the NOK and the SEK also shine using this method, while the less pro-cyclical EUR, CHF and JPY suffer. The pound too seems to posses some short-term downside. Ultimately, this tells us that if the global environment is indeed unfavorable to the U.S. dollar right now, we cannot ignore the strength of U.S. domestic factors. Consequently, we refrain from aggressively selling the USD during the tactical anticipated correction. Instead, if the global environment favors the pro-cyclical commodity currencies on a three-month basis, it is optimal to buy them on their crosses, especially against the CHF and JPY. Meanwhile, the pound has very little going for it, and selling it against the SEK or the NOK could still deliver ample gains.   Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Footnotes 1  Please see Foreign Exchange Strategy Special Report, "In Search Of A Timing Model" dated July 22, 2016, available at fes.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the U.S. has been mixed: January U.S. consumer confidence index surprised to the downside, coming in at 120.2.  U.S. unemployment rate in January increased to 4.0%, from a previous 3.9% reading; however, this data point was likely distorted by the government shutdown Non-farm payrolls in January surprised to the upside, coming in at 304k. The DXY index rebounded by 0.9% this week. Tactically, we remain bearish on the dollar, as we believe that the current easing in financial conditions will help global growth temporarily surprise dismal investor expectations. Nevertheless, we remain cyclical dollar bulls, as the Fed will ultimately hike more than what is currently priced this year, and as China’s current reflation campaign is about mitigating the downside to growth, not generating a new upswing in indebtedness and capex. Report Links: Global Liquidity Trends Support The Dollar, But... - January 25, 2019 So Donald Trump Cares About Stocks, Eh? - January 9, 2019 Waiting For A Real Deal - December 7, 2018 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 The recent data in euro area has been negative: The Q4 euro area GDP on a year-over-year basis fell to 1.2%, in line with expectations. Euro area headline inflation in January on a year-over-year basis decreased to 1.4%, from the previous 1.6% in December 2018, core inflation rose to 1.1%. January Markit euro area composite PMI fell to 51.0. Euro area retail sales in December fell to 0.8% on a year-over-year basis, from the previous 1.8%. In response to this poor economic performance, EUR/USD has fallen by 0.8% this week. We remain cyclically bearish on the euro, as we believe that the Fed will hike more than anticipated this cycle and that Europe is more negatively impacted by China’s woes than the U.S. is. Hence, slowing global growth will force the ECB to stay dovish much longer than expected. Moreover, our Intermediate Term Timing Model, is showing that the euro is once again trading at a premium to short term fundamentals. Report Links: 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Six Questions From The Road - November 16, 2018 Evaluating The ECB’s Options In December - November 6, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: Annual inflation increased to 0.4% from previous 0.3%, core inflation increased to 0.7% from 0.6%, and inflation ex fresh food increased to 1.1% from 0.9%. December retail trade weakened to 1.3% from the previous 1.4%. Japanese unemployment rate in December has fallen to 2.4%. January consumer confidence index fell to 41.9, underperforming the expectations. USD/JPY has risen by 0.3% this week. We remain bearish on the yen on a tactical basis. The recent FOMC meeting kept the U.S. key interest rate unchanged, so did many other central banks. The resulting ease in global financial conditions could be a headwind for safe havens, like the yen. Moreover, U.S. yields are likely to rise even after the easing in financial conditions is passed, as BCA anticipates the Fed to resume hiking in the second half of 2019. This will create additional downside for the yen. Report Links: Yen Fireworks - January 4, 2019 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 The recent data in Britain has been negative: Markit U.K. composite PMI has surprised to the downside, falling to 50.3 in January; service PMI dropped to 50.1 while construction PMI fell to 50.6.  Halifax house prices yearly growth, surprised to the downside, coming in at 0.8%. Finally, Markit Services PMI also underperform, coming in at 50.1. The Bank of England rate decided to keep rates on hold at 0.75%. GBP/USD has lost 0.8% this week. On a long-term basis, we remain bullish on cable, as valuation for the pound are attractive. However, we believe that the current stalemate in Westminster, coupled with the hard-nose approach of Brussels has slightly increase the probability of a No-deal Brexit. This political uncertainty implies that short-term risk-adjusted returns remains low. Report Links: Deadlock In Westminster - January 18, 019 Six Questions From The Road - November 16, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia has been negative: Building permits in December has surprised to the downside, coming in at -8.4% on a month-over-month basis.  December retail sales has slowed down, coming in at -0.4%. Finally, in December, with exports contracted at a -2% pace, and imports, at -6% pace. The RBA decided to leave the cash rate unchanged at 1.5%. While it was at first stable, AUD/USD ultimately has fallen by 2% this week. Overall, we remain bearish on the AUD in the long run. The unhealthy Australian housing market coupled with very elevated debt loads, could drag residential construction and household consumption down. Moreover, the uncompetitive Australian economy could fall into a potential liquidity trap as the credit conditions tighten further. Report Links: CAD And AUD: Jumping Higher To Plunge Deeper - February 1, 2019 Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 The recent data in New Zealand has been negative: The participation rate underperformed expectations, coming in at 70.9%. Moreover, employment growth also surprised to the downside, coming in at 0.1%. Finally, the unemployment rate surprised negatively, coming in at 4.3%. NZD/USD has fallen by 2.3% this week. Overall, we remain bullish on the NZD against the AUD, given that credit excesses are less acute in New Zealand than in Australia. Moreover, New Zealand is much less exposed to the Chinese industrial cycle than Australia. This means that is China moving away from its current investment-led growth model will likely negatively impact AUD/NZD. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The recent data in Canada has been negative: GDP has fallen to 1.7% on a year-over-year basis from the previous 2.2%. The December industrial production growth came in at -0.7% month-on-month, a negative surprise. Canadian manufacturing PMI in January decreased to 53. On the back of these poor data and weaker oil prices, USD/CAD rose by 1.6% this week, more than undoing last week’s fall. We expect the CAD to outperform other commodity currencies like the AUD and the NZD, oil prices are likely to outperform base metals on a cyclical basis. Moreover, the Canadian economy is more levered to the U.S. than other commodity driven economies. Thus, our constructive view on the U.S. implies a positive view on the CAD on a relative basis. Report Links: CAD And AUD: Jumping Higher To Plunge Deeper - February 1, 2019 Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2   Recent data in Switzerland has been mixed: Real retail sales yearly growth improved this month, coming in at -0.3% versus -0.6% last month. However, the SVME Purchasing Manager’s Index underperformed expectations, coming in at 54.3. EUR/CHF has fell 0.2% this week. Despite this setback, we remain bullish on EUR/CHF. Last year’s EUR/CHF weakness tightened Swiss financial conditions significantly and lowered inflationary pressures. Given that the Swiss National Bank does not want a repeat of the deflationary spiral of 2015, we believe that it will continue with its ultra-dovish monetary policy and increase its interventionism in the FX market, in order to weaken the franc, and bring back inflation to Switzerland. Moreover, on a tactical basis, the ease in financial conditions should hurt safe havens like the franc. Report Links: Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been negative: The December retail sales missed the consensus estimates, coming in at -1.80%. December credit indicator decreased to 5.4%. Registered unemployment rate in January has increased to 2.6%, surprising to the downside. USD/NOK has risen by 1.8% this week. We are positive on USD/NOK on a cyclical timeframe. Although we are bullish on oil prices, USD/NOK is more responsive to real rate differentials. This means, that a hikes later this year by the Fed will widen differentials between these two countries and provide a tailwind for this cross. Nevertheless, the positive performance of oil prices should help the NOK outperform non-commodity currencies like the AUD. We also expect NOK/SEK to appreciate and EUR/NOK to depreciate. Report Links: Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden has been negative: Consumer confidence surprised to the downside, coming in at 92. Moreover, retail sales yearly growth also underperformed expectations, coming in at 5.6%. Finally, manufacturing PMI came in line with expectations at 51.5. USD/SEK has risen by 2.2% this week. Overall, we remain long term bullish on the krona against the euro, given that Swedish monetary policy is much too easy for the current inflationary environment, a situation that will have to be rectified. However, given our positive view on the U.S. dollar on a cyclical basis, we are cyclically bullish on USD/SEK, since krona is the G-10 currency most sensitive to dollar moves. Report Links: Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Our non-consensus inflation and Fed views just got even more non-consensus: Media and sell-side commentators were quick to speculate about an end to the tightening cycle following Wednesday’s FOMC meeting, but we don’t see any basis for changing our stance. December and January have been a wild couple of months, … : It’s not unusual for a swing in one direction to be following by a swing in the other, but the S&P 500 went from the 2nd percentile in December to the 96th percentile in January. … and we’re turning to our equity checklist to regain our bearings: Checklists help us maintain a healthy distance from day-to-day swings and focus on the key swing factors. For now, we don’t think anything much has changed, but the scope for a repricing of the entire Treasury curve has gotten bigger: The wider the disparity between our terminal fed funds rate expectation and the market’s, the greater the potential for yields to readjust. We continue to believe markets are being complacent about inflation pressures; their presence will force the Fed off the sidelines and ultimately spell the end of the expansion. Feature Brutal arctic cold swept the Midwest and the Northeast Corridor last week as the polar vortex clamped down on Canada and the upper U.S. The weather didn’t do anything to cool investors’ revived ardor for stocks, however. After finally taking a break from its nearly uninterrupted four-week sprint from 2,350 to 2,670 (that’s nearly 14% in just 17 sessions), the S&P 500 hung around the 2,640 level that supported it repeatedly during its October, November and early December travails (Chart 1). Then came Wednesday’s FOMC statement and press conference, and the S&P even poked its head above the 2,700 level that would seem to present a fairly stiff challenge (Chart 2). Chart 12,640 Lent Support Once Again … 2,640 Lent Support Once Again … 2,640 Lent Support Once Again …   Chart 2... Will The Next Round Number Offer A Little Resistance? ... Will The Next Round Number Offer A Little Resistance? ... Will The Next Round Number Offer A Little Resistance? What Goes On One minute born, one minute doomed/ One minute up, and one minute down/ What goes on in your mind?/ I think that I am falling down If the conditions were polar out of doors, they were bipolar on traders’ screens. As much as the clients we spoke with in January were initially skeptical about our inflation view (it’s not dead) and our corresponding Fed call (at least three or four more hikes in response to budding price pressures), several of them seemed to come around before the meeting was over. They had a lot harder time with the two-part investment conclusion that risk assets would rally while the Fed was on hold, and the economy and corporate profits were able to gain a footing, before rolling over once the data become strong enough to bring the Fed back off the sidelines. Why would investors buy into the temporary part one? We offered the view that the selloff had gone too far, and seemed to have been founded upon a premise that the Fed had either already tightened into a recession, or had gotten uncomfortably close to doing so. We expect that a Fed pause will reveal that the market’s neutral-rate estimate had been way too low. Once the economy shows signs of life, and consensus earnings estimates stop declining and begin to rise again, stocks will rise, spreads will compress, and investors will get back to chasing performance. The renewed fundamental vigor could even allow the Fed to hike rates another couple of times without inspiring a new bout of market indigestion. After this week, we are the ones scratching our heads. The committee’s post-meeting statement did change more than it has since the gradual, 25-bps-per-quarter pace of hikes took hold at the end of 2016, but early January’s procession of Fed speakers who repeated “patience” like a mantra already telegraphed an extended pause. We did not read all that much into the substitution of “will be patient as it determines … [appropriate] adjustments” for “some further gradual increases,” even if the media and the markets did. We will have more to say about the Fed’s balance sheet in subsequent research, but suffice it to say for now that we do not think it will be terribly impactful. Bottom Line: While we were surprised by the intensity of the reaction to last week’s FOMC meeting, it remains our view that the pause in the Fed’s monetary tightening campaign will give equities and corporate bonds an opportunity to rally near their late September levels. Checking And Re-Checking Our Views Among our favorite trading-desk maxims is the advice to plan your trade, and trade your plan. Checklists help us plan and help establish a repeatable process. Having a process to fall back on when rapid-fire decisions have to be made allows an investor to react to conditions as they arise without suffering from analysis paralysis, just like a seasoned trader. Checklists aren’t magic, but they can help an investor keep his/her bearings in the midst of market tides that seem to sweep all before them. Confronting the combination of December’s despondency and January’s euphoria, we return to the equity downgrade checklist we rolled out in mid-October, and last formally reviewed in mid-November. The checklist attempts to look out for threats on four fronts: a looming recession, which would bring the curtain down on the bull market; earnings pressure independent of a full-fledged recession; inflation pressures that could compel the Fed to tighten policy with a renewed sense of urgency; and unsustainably positive sentiment, which could set equities up for a fall. At the moment, only the recession category could arguably be said to be flashing yellow. Recession Watch All three factors in our simple recession indicator are moving in the wrong direction, but the yield curve is the only one at a potentially problematic level (Chart 3, top panel). It would not be a disaster for equities or the economy if the curve inverted – it is habitually early, inverting a year before a recession, on average, and six months before the S&P 500 peaks – but we don’t think it will until markets begin pricing in new rate hikes. Assuming the three-month rate won’t move until they do, the curve could only invert if the 10-year Treasury yield were to fall into the 2.40s (Chart 3, bottom panel), which would be incompatible with our constructive economic view. By the time the Fed resumes hiking, the curve should have gained some breathing room, as an economy strong enough to require further tightening merits a 10-year Treasury yield at or above 3%. Chart 3The Curve Isn’t Ready To Invert Just Yet The Curve Isn’t Ready To Invert Just Yet The Curve Isn’t Ready To Invert Just Yet Year-over-year growth in the leading economic indicator decelerated sharply over the last three months of 2018 (Chart 4). It is a ways away from contracting, however, and only a series of hefty month-over-month drops could make it do so this quarter. Our estimate of the equilibrium fed funds rate remains 50 bps above the 2.5% target rate and our model projects that equilibrium will rise throughout the rest of the year. If its 3.25-3.5% year-end estimate is on the money, the Fed would have to hike three or four more times by year end to provide the restrictive backdrop required for a recession. Chart 4Decelerating, But Not Contracting Decelerating, But Not Contracting Decelerating, But Not Contracting Checking the final item in the recession section of the checklist, a 33-basis-point rise in the three-month moving average of the unemployment rate, would require a sharp hiring slowdown and/or a significant pickup in labor force participation. The January employment report makes a drop-off in hiring appear improbable, and we are skeptical that the participation rate can keep rising in spite of the drag from retiring baby boomers. If the unemployment rate were to rise because of a rising part rate, however, it might well be more likely to extend the expansion than end it. Bottom Line: The elements of our recession indicator are deteriorating, albeit slowly. A recession may not be more than a year away, but we can’t see it occurring until the Fed turns more hawkish. Earnings Pressure We have repeatedly offered our view that the labor market is as tight as a drum in print, calls and meetings. That is good for the economy because it increases households’ ability to consume, but it will eventually squeeze profit margins and induce the Fed to remove monetary accommodation. Compensation costs shouldn’t hurt margins if they grow at or below the sum of the rate of price-level and productivity gains. If inflation grows at the Fed’s 2% target, and productivity maintains its rough 1.25% growth pace, compensation growth of 3.25% shouldn’t pose a problem, but gains exceeding 3.5% might become problematic. The total compensation series of the employment cost index ticked up to 2.9% in the fourth quarter, but an assault on 3.25-3.5% does not appear to be at hand (Chart 5). Chart 5Wages Aren’t Pressuring Margins Yet Wages Aren’t Pressuring Margins Yet Wages Aren’t Pressuring Margins Yet Dollar strength is a margin headwind for any company competing with multinationals, at home or abroad. After peaking in mid-November and mid-December, the DXY index has rolled over and is back to its early October level (Chart 6). The fourth-quarter blowout in spreads had us poised to check the “rising corporate yields” box, but there’s no need following last month’s reversal (Chart 7). The savings rate has recovered enough to support spending, and there’s currently no sign that consumers are about to pull back (Chart 8). We are monitoring conditions in emerging markets for spillover into the U.S., but the dollar’s decline and the broad recovery in risk assets worldwide have taken pressure off of EM corporate and sovereign borrowers. Chart 6The Dollar's Backed Off … The Dollar's Backed Off … The Dollar's Backed Off …   Chart 7... And Bond Yields Have, Too ... And Bond Yields Have, Too ... And Bond Yields Have, Too   Chart 8Ready, Willing And Able Ready, Willing And Able Ready, Willing And Able Bottom Line: None of our proxy indicators suggests that corporate earnings face meaningful near-term pressure, either from tighter margins or lower revenues. Inflation Pressures Inflation poses a threat to equities if it makes the Fed uncomfortable enough to pull the plug on the expansion to keep the economy from overheating, or if it makes investors uncomfortable enough to apply a significant haircut to earnings multiples. Given the Fed’s “symmetric” target, we don’t think it will get anxious about core PCE inflation unless it threatens to exceed 2.5% (Chart 9). The 10-year and 5-year-on-5-year TIPS inflation breakevens have slid in lockstep with oil prices, and are nowhere near the 2.3-2.5% range that is consistent with the Fed’s 2% core PCE target (Chart 10); they offer no hint that longer-run inflation expectations might become unanchored. CPI is the go-to inflation series for investors and the media, and with both headline and core hanging around 2%, it is well short of levels that would promote anxiety among the public (Chart 11). Chart 9Realized Inflation Remains Contained … Realized Inflation Remains Contained … Realized Inflation Remains Contained …   Chart 10... And Expectations Have Only Fallen ... And Expectations Have Only Fallen ... And Expectations Have Only Fallen   Chart 11Nothing To See Here Nothing To See Here Nothing To See Here Bottom Line: We expect that unnecessary fiscal stimulus and an extremely tight labor market will eventually produce inflation, but they’re not testing investors’ complacency yet. Overexuberance Runaway sentiment could spark a nasty correction if it sets the bar for expectations so high that stocks inevitably disappoint. BCA’s composite sentiment indicator, which aggregates the results from surveys of individual investors, professional investors and advisors, is at the lower end of its range, though not yet at levels that have often marked equity bottoms (Chart 12, bottom panel). Before falling with the S&P 500 last January, the share of consumers expecting stock prices to rise over the next twelve months had reached a level consistent with past peaks (Chart 13, bottom panel). It has since fallen to the lower end of its range, and would seem to suggest that investors had nearly given up on stocks when the January survey was taken. Chart 12Investor Sentiment Is Muted … Investor Sentiment Is Muted … Investor Sentiment Is Muted …   Chart 13... And So Is The General Public’s ... And So Is The General Public’s ... And So Is The General Public’s Bottom Line: The fourth-quarter decline pushed investor sentiment from around the higher reaches of its historical range to a position well below the mean. From a contrarian perspective, washed-out sentiment could help extend the rally. Investment Implications Our equity downgrade checklist gives U.S. equities a clean bill of health. Although potential gains are lower now with the S&P 500 trading above 2,700 than they were when it was trading below 2,500 at the beginning of the year, we do not see a fundamental reason to downgrade equities from overweight. The multiple expansion required to produce a new closing high might be a stretch, but we believe the S&P 500 can advance well into the 2,800s. We upgraded corporate credit last week, and expect that spreads will narrow as the Fed stays on the sidelines. One should not expect new tights in spreads, but there is potential for investors to augment their coupon spreads with some modest capital appreciation. We dislike Treasuries, especially at longer maturities, even more than we did before last week’s bull flattening of the yield curve. With rate hikes fully priced out, the only way the 10-year Treasury yield could fall even further would be if the Fed cut rates, and that scenario is flatly incompatible with our assessment of the economy’s strength.   Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com

Highlights We believe 2019 and 2020 will be a tale of two markets; … : The latter stages of the long post-crisis party may be rewarding, but the inflection points that will herald a bear market and a recession are not too far off. … the first will be broadly favorable for investors in risk assets, … : The combination of ample monetary accommodation and the indiscriminate fourth-quarter markdown in risk assets provides the springboard for one last advance. … but the second will mark the end of the post-crisis bull market, … : Nothing lasts forever, and we wouldn’t be overweight risk assets at this stage were it not for last quarter’s selloff. … as the Fed pulls the plug on the expansion: Our base-case scenario does not call for a deep or lengthy recession, but once Fed policy transits from accommodative to restrictive, the going will become much rougher for stocks, corporate bonds and the economy. Feature We spent the week of January 14th meeting with clients in South Africa. It is always good to exchange views with investors, especially when they are at a distant remove from the echo chamber which inevitably colors our perspective, no matter how much we try to resist it. It was also a pleasure to swap a week of winter at home for summer abroad, where our clients’ golf talk helped boil our views down to a simple analogy. We see the next twelve to twenty-four months as a double-breaker putt. 2019-20’s Double Breaker The undulating terrain of some golf-course greens sets up putts that break one way and then the other on their path to the hole. That is the way we view the next twelve-plus months, following the fourth quarter’s sharp, sudden tightening in financial conditions (Chart 1). The selloff pulled hard on the financial-condition reins, checking some of the pressure on the economy to overheat, and allowing the Fed to pause its rate-hiking campaign. Relieved investors immediately bid stocks higher, and corporate-bond spreads tighter, retracing nearly half of the tightening in financial conditions, but we expect the Fed to remain on the sidelines until June anyway. Chart 1A Swift Tightening In Financial Conditions A Swift Tightening In Financial Conditions A Swift Tightening In Financial Conditions A Fed pause delays the date when monetary policy will turn restrictive by a few months. We see the monetary policy inflection point as the key event presaging all of the inflection points that matter most to investors: the transition from an equity bull market to a bear market; the point at which credit performance deteriorates, and spreads widen, in earnest; and the transition from expansion to recession. The delay, and the lower entry points provided by the selloff, set the stage for a last hurrah in risk assets over the next six to nine months. With the Fed in the background, investors will be able to focus on the above-trend growth driven by the remaining fiscal thrust (Chart 2) and what we expect will be better calendar 2019 S&P 500 earnings than investors currently anticipate. Chart 2Fiscal Fuel Will Keep 2019 Growth Above Trend Fiscal Fuel Will Keep 2019 Growth Above Trend Fiscal Fuel Will Keep 2019 Growth Above Trend Better-than-expected conditions will ultimately prove to be self-limiting, however. The more momentum the economy gathers while the Fed is on hold, the more budding inflation pressures will become evident. The more that inflation pressures reveal themselves, the more forcefully the Fed will have to act to counter them. The upshot for investors is that the last burst of the good times will necessarily bring forth a slowdown, and they therefore confront a putt that will break twice over the next year or two: equities and spread product will outperform Treasuries and cash over the first stretch, but underperform over the next.1 Inflation Pressure Our oft-repeated view that the fiscal stimulus will promote inflation pressures is not at all controversial. Force-feeding stimulus into an economy already operating at capacity should lead to inflation. Businesses and other investors, recognizing that the above-trend boost in aggregate demand is temporary and unsustainable, will not expand capacity to meet it. Imports may relieve some of the pressure, but prices should nonetheless rise as aggregate demand exceeds aggregate supply. Inflation pressures emanating from the labor market provoke much more pushback. Investors, tired of hearing that a pickup in wages is right around the corner, harbor considerable doubts about the Phillips Curve, which posits that there is an inverse relationship between the unemployment rate and wage growth. We acknowledge that the 1960s belief in a mechanical tradeoff between inflation and unemployment – policymakers could have lower inflation if they were willing to tolerate higher unemployment, or lower unemployment if they were willing to tolerate higher inflation – was shattered by the stagflation of the 1970s. We further acknowledge that the relationship between unemployment and compensation is not linear. We continue to believe, however, that the laws of supply and demand apply, and that the relationship between compensation and unemployment has been slow to assert itself this time around because the Phillips Curve is kinked. That is to say that the sensitivity of wage growth to a drop in unemployment is a function of the level of the unemployment rate itself. A decline in unemployment from 10% to 9%, 9% to 8%, or 8% to 7% does not exert upward pressure on wages because there are many more qualified candidates than there are openings at such elevated unemployment rates (Chart 3, top panel). When the unemployment rate is 5% or less, on the other hand, wages do respond to unemployment declines because the lack of labor market slack ensures that employers have to compete to attract qualified candidates (Chart 3, bottom panel). Chart 3 Estimates of the United States’ natural rate of unemployment in recent years have typically hovered around 5%. Over the 50-plus years covered by the average hourly earnings (AHE) series, real AHE growth has tended to peak (Chart 4, bottom panel) following unemployment’s sub-natural-rate trough (Chart 4, top panel). It has not yet reached an elevated level, but wages did begin accelerating sharply a year after the unemployment gap turned negative in early 2017. With the unemployment rate on track to continue to fall throughout 2019 (it only takes about 110,000 net new jobs a month to hold it in place), we expect that real AHE growth has further to run. Chart 4Don't Count Dr. Phillips Out Just Yet Don't Count Dr. Phillips Out Just Yet Don't Count Dr. Phillips Out Just Yet Taking the analysis a step further to consider real wage growth relative to productivity growth exhibits an even stronger link with the unemployment gap. From the early ‘70s through 2001, when productivity and real wages grew at the same rate (Chart 5, middle panel), real wages fell behind productivity when the unemployment gap was positive and caught up when it was negative (Chart 5, bottom panel). Capital has seized a disproportionate share of the gains in productivity since 2002, with the real-wages-to-productivity ratio able to stabilize only when the unemployment gap turned negative from 2006 to 2008. Chart 5Productivity-Adjusted Real Wages Rise When Unemployment Bottoms Productivity-Adjusted Real Wages Rise When Unemployment Bottoms Productivity-Adjusted Real Wages Rise When Unemployment Bottoms We expect that the coming cyclical trough in the unemployment gap will be consistent with past troughs, which have been associated with cyclical peaks in compensation gains. The linkage between compensation and consumer prices isn’t firmly established, but investors don’t have to sweat it. As long as the Fed perceives a connection, which it clearly does, it can be counted upon to respond to higher wages by tightening policy. A swift recovery in oil prices – our Commodity & Energy Strategy service sees Brent crude averaging $80/barrel, and WTI averaging $74, across 2019 – will also help keep the Fed’s attention squarely focused on price stability after ten years of full-employment fixation. Bottom Line: Unnecessary fiscal stimulus will continue to exert upward pressure on prices, while an extremely tight labor market will place steady upward pressure on wages. The Fed will respond by removing accommodation, pushing the fed funds rate above the neutral level, and bringing down the curtain on the record-long expansion sometime in 2020. Upgrading Corporate Bonds We noted two weeks ago that the spread-widening in high-yield corporate bonds was extreme, and that overweighting spread product would mesh well with our renewed equity overweight. Our U.S. Bond Strategy colleagues have since upgraded credit,2 and we are following their lead. We now recommend that investors overweight equities, underweight fixed income and equal-weight cash. Within fixed income, we recommend that investors significantly underweight Treasuries while overweighting both investment-grade and high-yield corporate bonds. Consistent with our above-consensus inflation expectations, we prefer TIPs to nominal Treasuries. We harbor no illusions that a new credit cycle has begun. It is late in an already lengthy cycle, and we view the projected near-term decline in high-yield default rates as a final unwind of the default spike that accompanied the shale-drilling rout in 2016 (Chart 6). We do not expect a recession in 2019, but the next one is likely not too far off, and defaults begin to pick up well ahead of a recession. Our spread-product upgrade is an opportunistic short-term move, not a change in our cyclical view. Chart 6A New Credit Cycle Has Not Begun A New Credit Cycle Has Not Begun A New Credit Cycle Has Not Begun High-yield spreads widened so much in the fourth quarter, relative to their history, that their capital-gain prospects have flipped. We had been at equal weight, anticipating an eventual move to underweight, because spreads were unusually tight. The capital-gain stretch of the cycle was long gone, and excess returns over Treasuries were limited to coupon spreads that were likely to be eroded by capital losses as spreads widened ahead of an approaching recession. The lurch in spreads from the 25th percentile to the 75th percentile in double-B, B and triple-C bonds (Chart 7) restores potential capital gains as a cushion that should protect the coupon spread against unanticipated economic weakness. Chart 7Irrational Gloom Irrational Gloom Irrational Gloom The Fed’s newly conciliatory stance should support spread product just as it should support equities. All three monetary-policy elements of our bond strategists’ peak-spread checklist are issuing the all-clear signal: twelve-month fed funds rate hike projections have collapsed (Chart 8, second panel), gold has revived (Chart 8, third panel), and the dollar’s relentless upward march has finally been halted (Chart 8, bottom panel). Chart 8Monetary Policy Argues For Lower Spreads ... Monetary Policy Argues For Lower Spreads ... Monetary Policy Argues For Lower Spreads ... The jury is still out on the global-growth elements of our bond team’s peak-spread checklist. Our China Investment Strategy service’s Market-Based China Growth Indicator looks spry3 (Chart 9, third panel), and industrial mining stocks may be in the midst of bottoming (Chart 9, bottom panel), but the CRB raw industrials index is still scuffling (Chart 9, second panel). A blowout in spreads accompanied by a less-hawkish Fed and rebounding global growth would be a no-brainer reason to own spread product, but two out of three ain’t bad, and spreads would not have blown out in the first place if global growth were poised to surge. The biggest threat to our constructive economic and market views is a slowdown in China, and its uncertain direction is a risk to overweighting credit. On balance, though, we believe the current level of option- and default-adjusted spreads adequately compensate credit investors over the next three to six months, especially after factoring in the Fed’s benign turn. Chart 9... But The Jury's Still Out On Global Growth ... But The Jury's Still Out On Global Growth ... But The Jury's Still Out On Global Growth Bottom Line: We are upgrading spread product to take advantage of its fourth-quarter selloff and a Fed pause that may last until June, despite uncertainty around the global growth outlook.   Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com   Footnotes 1 The wise men and women gathered at the Barron’s annual roundtable foresee a similar setup, but with the direction reversed. They expect markets and the U.S. economy to encounter rough going in the first half of 2019 before conditions become more hospitable in the second half and in 2020, ahead of the next election. “Goodbye to Gloom,” Rublin, Lauren R., Barron’s, January 14, 2019, pp. 21-34. 2 Please see the January 15, 2019 U.S. Bond Strategy Weekly Report, “Buy Corporate Credit,” available at usbs.bcaresearch.com. 3 Please see the November 21, 2018 China Investment Strategy Weekly Report, “Trade Is Not China’s Only Problem,” available at cis.bcaresearch.com.

Highlights The Eurostoxx600’s short bursts of outperformance require either global technology to underperform or the euro to underperform. EM’s short bursts of outperformance usually coincide with the global healthcare sector’s short bursts of underperformance. Remain tactically overweight to Europe and EM, but expect to reverse position later in the year. The ECB is justified in setting an accommodative monetary policy, but it is not justified in setting an ultra-accommodative monetary policy. Soft inflation prints will cap the extent to which bond yields can rise in the near term. Italian BTPs are an attractive long-term proposition, especially relative to other euro area bonds. Feature Chart of the WeekEuro Area Inflation Appears To Be Underperforming... Euro Area Inflation Appears To Be Underperforming... ...But Adjusted For Its 'Negative Space' It Is Not Euro Area Inflation Appears To Be Underperforming... ...But Adjusted For Its 'Negative Space' It Is Not ...But Adjusted For Its 'Negative Space' It Is Not Euro Area Inflation Appears To Be Underperforming... ...But Adjusted For Its 'Negative Space' It Is Not Euro Area Inflation Appears To Be Underperforming... ...But Adjusted For Its 'Negative Space' It Is Not     “The music is not in the notes, but in the silence between”  – Wolfgang Amadeus Mozart As Mozart pointed out, true awareness lies not in appreciating what is there, but in appreciating what is not there. This is the concept of ‘negative space’: to understand an object, you have to understand the empty space that defines it. This week’s report extends the concept of negative space into the fields of investment and economics to make more sense of Europe’s recent past and its future. The Negative Space In Stock Markets Picking stock markets is a relative game. This means that what a stock market does not contain – its negative space – is often more important than what it does contain (Table I-1). This is not an abstract proposition, it is a mathematical truth. When a major global sector is strongly outperforming, a stock market’s zero or near-zero exposure to that sector will create a strong headwind to relative performance. And when the major sector is underperforming, its absence in the stock market will necessarily create a strong tailwind to relative performance. Chart I- For the European stock market, the negative space is technology, a sector in which European equities have a near-zero exposure. But there is another factor to consider: the currency. The technology sector’s global profits are mostly translated into shares quoted in dollars, while European equities’ global profits are mostly translated into shares quoted in euros. It follows that the Eurostoxx600’s short bursts of outperformance require at least one of the following two conditions (Chart I-2): Chart I-2The Eurostoxx600 Usually Outperforms When Technology Underperforms The Eurostoxx600 Outperforms When Technology Underperforms The Eurostoxx600 Outperforms When Technology Underperforms Technology to underperform. Or: The euro to underperform. For emerging market (EM) equities, the negative space is healthcare, a sector in which EM has a near-zero exposure. Therefore unsurprisingly, EM’s short bursts of outperformance usually coincide with the healthcare sector’s short bursts of underperformance (Chart I-3). Sceptics will raise an obvious question: what is the cause and what is the effect? The answer is that sometimes EM is the driver of healthcare relative performance, and at other times vice-versa. Chart I-3EM Usually Outperforms When Healthcare Underperforms EM Outperforms When Healthcare Underperforms EM Outperforms When Healthcare Underperforms A sharp slowdown emanating from emerging economies would undoubtedly drag down global equities. In the ensuing bear market, the more defensive healthcare sector would almost certainly outperform the financials. Under these circumstances the direction of causality would clearly be from EM to healthcare’s relative performance. On the other hand, absent a major bear market, in a common or garden reassessment of sector relative valuations versus their growth prospects, the causality would run in the other direction: sector rotation would drive the relative performance of equity markets: healthcare’s underperformance would help EM to outperform; and technology’s underperformance would help European equities to outperform. As we have explained in recent reports, the major sectors – and therefore the major stock markets – are now in this latter configuration in a brief countertrend burst before reverting to their structural trends later this year (Chart I-4 and Chart I-5). So for the time being, remain tactically overweight to Europe and to EM.1 Chart I-4The Eurostoxx600 Outperformance Is A Countertrend Burst The Eurostoxx600 Outperformance Is A Countertrend Burst The Eurostoxx600 Outperformance Is A Countertrend Burst Chart I-5The EM Outperformance Is A Countertrend Burst The EM Outperformance Is A Countertrend Burst The EM Outperformance Is A Countertrend Burst The Negative Space In European Inflation And Unemployment On the face of it, inflation is structurally underperforming in the euro area versus the U.S. But on closer examination this is only because of what the euro area harmonised index of consumer prices (HICP) does not contain: owner occupied housing costs – which tend to rise faster than other items in the price basket. Adjusting for this negative space in the HICP, the euro area and the U.S. have both achieved the exact same modest structural inflation, which their central banks define as ‘price stability’ (Chart of the Week).   In a similar vein, the unemployment rate disregards changes in the labour participation rate. When people join the labour force – as they are in their tens of millions in Europe (Chart I-6) – the joining cohort tends to have a slightly higher unemployment rate given its inexperience in the formal labour market. So the joiners tend to lift the overall unemployment rate too. The paradox is that the percentage of the working age (15-74) population in employment also rises at the same time. Looking at this alternative measure of labour market health, the euro area employment market is in a structural uptrend and much healthier than it was at the peak of the last cycle in 2008 (Chart I-7). Chart I-6Europeans Are Joining The Labour Force In Their Tens Of Millions Europeans Are Joining The Labour Force In Their Tens Of Millions Europeans Are Joining The Labour Force In Their Tens Of Millions   Chart I-7The European Employment To Population Ratio Is In A Structural Uptrend The European Employment To Population Ratio Is In A Structural Uptrend The European Employment To Population Ratio Is In A Structural Uptrend Hence, once we adjust for what is missing in euro area inflation and the euro area unemployment rate, neither inflation nor employment market performance appear to be too cold or too hot. This means that the ECB is justified in setting an accommodative monetary policy, but it is not justified in setting an ultra-accommodative monetary policy. The Negative Space In Monetary Policy The negative space in monetary policy is literally the negative space, by which we mean that interest rates cannot go deeply into negative territory. With the deposit rate already at -0.4 percent, the ECB’s room for manoeuvre in the dovish direction is limited. On the other hand, neither can monetary policy get meaningfully hawkish in the near term. The simple reason is that the ECB, like other central banks, is now even more wedded to ‘data-dependency’. The problem with this is that the data on which the central banks depend is always backward-looking. So policy will reflect what was happening one or two months ago, rather than what is happening now. Specifically, the plunge in the price of crude oil will depress both headline and core inflation rates (Chart I-8). And the recent wobble in risk-asset prices has weighed down some sentiment surveys (Chart I-9). Having promised to be data-dependent, the central banks have effectively created ‘an algorithm’ for their policy setting, an algorithm which everyone can see and read. It follows that the data, especially soft inflation prints, will cap the extent to which bond yields can rise in the near term. Chart I-8The Plunge In The Price Of Crude Will Subdue Inflation The Plunge In The Price Of Crude Will Subdue Inflation The Plunge In The Price Of Crude Will Subdue Inflation Chart I-9The Stock Market Sell-Off Hurt Sentiment The Stock Market Sell-Off Hurt Sentiment The Stock Market Sell-Off Hurt Sentiment However, core euro area bonds are an unattractive long-term proposition. When yields are so close to their lower bound, there is little scope for a capital gain, even in a crisis. Whereas the scope for a capital loss is considerably greater. By contrast, Italian BTPs are an attractive long-term proposition, especially relative to other euro area bonds. Almost all of the 2.75 percent yield on 10-year BTPs is a premium for euro break-up risk. Yet the populists in Italy do not want to break up the euro. And despite their rhetoric, neither do the populists in the core countries. To understand why, we must explain the negative space of ECB QE. When the ECB bought BTPs from Italian investors, what the Italian investors did not do was deposit the cash in Italian banks. Instead, they deposited it in German banks – something that we can see very clearly in the euro area’s mirror-image Target2 imbalances (Chart I-10). Chart I-10ECB QE Has Exacerbated The Target2 Imbalances ECB QE Has Exacerbated The Target2 Imbalances ECB QE Has Exacerbated The Target2 Imbalances In effect, the core countries, through their equity in the Eurosystem, are holding a huge quantity of Italy’s €2.7 trillion of BTPs. Meaning that if the euro broke up, the core countries would be the ones picking up the tab. For the euro area’s future, this is the most important negative space of all. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System* There are no new trades this week. But all four of our open trades – long PKR/INR, industrials versus utilities, litecoin and ethereum, and MIB versus Eurostoxx – are in profit. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Footnotes 1 Please see the European Investment Strategy Weekly Report, “Why 2019 Is The Mirror-Image Of 2018”, dated January 10, 2019, available at eis.bcaresearch.com. Fractal Trading Model Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Yield Curve Drivers: A rebound in rate hike expectations will cause the curve to steepen somewhat during the next few months, though accelerating wages limit the upside. The yield curve will not invert until after long-dated inflation expectations are fully re-anchored, probably not until late in the year. Yield Curve Positioning: Correlations that have been in place since the financial crisis show that the 5-year and 7-year maturities are most sensitive to changes in near-term rate hike expectations. With the discounter likely to move higher in the coming months, investors should favor yield curve trades that are short that portion of the curve. Investment Recommendation: Close our recommended long 2-year short 1-year/5-year trade for a profit of 2 bps. Replace it with a position short the 7-year bullet and long a duration-matched 2-year/30-year barbell. Feature The yield curve flattened throughout most of 2018, and actually fell enough that talk of curve inversion hit a fever pitch last November, around the same time that the market started to doubt the Fed’s ability to lift rates (Chart 1). As of today, the 2/10 Treasury slope sits at a mere 17 basis points, but we don’t see it falling below zero any time soon.1 Chart 1Too Soon For Curve Inversion Too Soon For Curve Inversion Too Soon For Curve Inversion In this week’s report we consider the factors that will determine how the slope of the curve evolves over the next few months, and also recommend an investment strategy to take advantage of those movements. Yield Curve: Macro Drivers Driver 1: Rate Hike Expectations The number one factor that will influence the slope of the yield curve in the coming months is the market’s assessment of the near-term path for Fed rate hikes. Chart 2 shows the 5-year rolling correlation between monthly changes in the 2/10 slope and monthly changes in our 12-month Fed Funds Discounter. A positive correlation means that the 2/10 slope steepens when the market prices in more rate hikes and flattens when it prices in fewer hikes. A negative correlation means that the slope flattens when the market prices in more hikes and steepens when it prices in fewer hikes. Chart 2Rising Rate Expectations = Steeper 2/10 Slope Rising Rate Expectations = Steeper 2/10 Slope Rising Rate Expectations = Steeper 2/10 Slope The correlation was consistently negative throughout the pre-crisis period because the 2-year yield reacted more to changes in near-term rate hike expectations than the 10-year yield. In other words, a given increase (decrease) in the discounter would lead to a larger increase (decrease) in the 2-year yield than in the 10-year yield, and the curve flattened (steepened) as a result. But this correlation flipped following the Great Recession. Zero-bound interest rates and Fed forward guidance were an important reason for the switch. But even during the past few months, as the 12-month discounter fell from 66 bps in early November to -1 bp currently, the 10-year yield fell by 45 bps and the 2-year yield by only 36 bps. Even with interest rates off zero and the Fed scaling back its forward guidance, the positive correlation between the 2/10 slope and the 12-month discounter persists. We think that the 12-month discounter is close to its near-term bottom. Our Fed Monitor has fallen somewhat in recent months but it remains above zero, suggesting that the economy requires further monetary tightening (Chart 3). A look at the three components of our Monitor gives us even more confidence that the discounter is near its trough. The economic growth component of the Monitor is nicely above zero (Chart 3, panel 3), and the inflation component continues to trend up (Chart 3, panel 4). All of the Fed Monitor’s recent weakness can be attributed to tighter financial conditions (Chart 3, bottom panel). As we discussed in last week’s report, now that the market views Fed policy as much more accommodative, it is only a matter of time before financial conditions ease.2 Chart 3Fed Monitor Still Suggests Tightening Fed Monitor Still Suggests Tightening Fed Monitor Still Suggests Tightening In fact, some easing has already begun (Chart 4): Chart 4Financial Conditions Starting To Ease Financial Conditions Starting To Ease Financial Conditions Starting To Ease The stock-to-bond total return ratio has bottomed (Chart 4, top panel) High-Yield spreads have peaked (Chart 4, panel 2) The VIX has moderated (Chart 4, panel 3) The trade-weighted dollar has started to depreciate (Chart 4, bottom panel) Ironically, easier financial conditions will give the Fed the green light to re-start rate hikes, probably by June, and this could re-test risk assets in the second half of the year. But between now and then, a move higher in 12-month rate expectations will apply some steepening pressure to the 2/10 slope. Driver 2: Inflation Expectations Instead of looking at nominal yields and rate hike expectations, another approach is to split yields into their real and inflation components. This is potentially revealing in the current environment since a large portion of the recent drop in yields was driven by the cost of inflation compensation. Since the November 8 peak in the discounter, the cost of 10-year inflation protection fell 26 bps and the real 10-year yield fell 19 bps. The cost of 2-year inflation protection declined 46 bps while the real 2-year yield actually rose 10 bps. Based on those numbers, it is evident that when the cost of inflation compensation fell alongside the oil price, it exerted a steepening pressure on the yield curve that was offset by a flattening in the real yield curve. One might conclude that a rebound in inflation will cause the curve to flatten going forward. That is probably true in the event of a pure inflation shock that does not impact global growth. But such a shock is highly unlikely. Oil (and other commodity) prices fell during the past few months because of a slowdown in global growth. A rebound in commodity prices that drives inflation higher will almost certainly occur alongside stronger global growth. In other words, splitting nominal yields into the real and inflation components probably doesn’t get us any closer to figuring out the near-term path for the yield curve. A better way to incorporate the cost of inflation compensation into our thinking about the yield curve is to focus on the 5-year/5-year forward TIPS breakeven inflation rate. That rate is currently 1.99%, well below the range of 2.3%-2.5% that has historically been consistent with well-anchored inflation expectations (Chart 5). Chart 5Inflation Expectations Are Too Low For The Fed Inflation Expectations Are Too Low For The Fed Inflation Expectations Are Too Low For The Fed It is difficult to believe that the Fed would allow the yield curve to invert with the 5-year/5-year breakeven rate so low. The combination of an inverted yield curve and below-target inflation expectations would signal that the Fed wants to run a restrictive monetary policy before inflation has fully recovered. That would be completely contrary to the Fed’s mandate. From this argument, we reason that the 2/10 slope is unlikely to sustainably fall below zero until the 5-year/5-year forward TIPS breakeven rate is at least above 2.3%. With the 2/10 slope already at 17 bps, this means it is much more likely to stay near its current level or steepen somewhat during the next few months. Driver 3: Wage Growth The third factor driving our yield curve view is the pace of wage growth. Stronger wage growth is tightly correlated with a flatter yield curve, though the yield curve tends to lead wage growth by 6-12 months (Chart 6). Chart 6A Flatter Curve Leads Faster Wage Growth Higher Wage Growth = Flatter Curve A Flatter Curve Leads Faster Wage Growth Higher Wage Growth = Flatter Curve A Flatter Curve Leads Faster Wage Growth Higher Wage Growth = Flatter Curve In fact, a typical cyclical pattern is for the 2/10 slope to flatten rapidly and then stay at a low (but positive) level for some time as wage growth catches up. In that sense, this cycle is playing out just like every other. The yield curve has already undergone its large flattening and wage growth is now accelerating to catch up. Bottom Line: The three factors discussed above lead us to expect a small amount of curve steepening during the next few months. A rebound in rate hike expectations due to easier financial conditions will cause the curve to steepen, though accelerating wages limit the upside. The yield curve will not invert until after long-dated inflation expectations are fully re-anchored, probably not until late in the year. Yield Curve Positioning In the first section of this report we noted that the 10-year yield fell by more than the 2-year yield between the early-November peak in the 12-month discounter and today. But Table 1 shows that the 5-year and 7-year yields fell by even more. This is the expected result. Table 1Treasury Curve From Peak In 12-Month Discounter To Present Don't Position For Curve Inversion Don't Position For Curve Inversion Turning once again to the correlations between different segments of the yield curve and our 12-month discounter, we see that yield curve segments out to the 5-year maturity point are all positively correlated with the 12-month discounter. Also, curve segments beyond the 7-year maturity point are all negatively correlated with the discounter. The 5/7 slope has virtually no correlation (Chart 7). Chart 75-Year & 7-Year Are Most Sensitive To Rate Expectations 5-Year & 7-Year Are Most Sensitive To Rate Expectations 5-Year & 7-Year Are Most Sensitive To Rate Expectations These correlations tell us that we should expect the 5-year and 7-year yields to move the most in response to changes in the 12-month discounter. In other words, if we expect the discounter to move higher in the coming months we should maintain short exposure to this part of the curve. This short exposure should be offset by long exposure at either the very short-end or the very long-end of the curve, where yields will see less upside when the discounter rebounds. To figure out where to focus this long exposure we can turn to our butterfly spread models.3 Table 2 presents the raw residuals from our butterfly spread models. These models are based on regressions of different butterfly spreads versus the slope of the yield curve segment that spans the two wings of the barbell portion of the trade. For example, Table 2 shows a residual of -9 bps for the 5-year bullet relative to the 2/10 barbell. This means that the 5-year appears 9 bps expensive versus the 2/10 barbell, given where the slope of the 2/10 curve is today. Table 3 shows the standardized residuals from the different curve models so that they can be compared against each other. Table 2Butterfly Strategy Valuation: Residuals Don't Position For Curve Inversion Don't Position For Curve Inversion Table 3Butterfly Strategy Valuation: Standardized Residuals Don't Position For Curve Inversion Don't Position For Curve Inversion Notice in Tables 2 and 3 that almost all of the numbers are negative. This means that bullet trades are currently expensive relative to barbell trades. Using our criteria of wanting to be short the 5-year or 7-year part of the curve, we can use the tables to see that a position short the 7-year bullet and long the duration-matched 2-year/30-year barbell has an attractive standardized residual of -1.00. This appears to be the most attractive curve trade for the current environment. As such, today we close our current yield curve recommendation to favor the 2-year bullet over the 1-year/5-year barbell for a gain of 2 bps. This recommendation had been in place since November 5. In its place, we initiate a recommendation to go long a duration-matched barbell consisting of the 2-year and 30-year maturities and short the 7-year note. Bottom Line: Correlations that have been in place since the financial crisis show that the 5-year and 7-year maturities are most sensitive to changes in near-term rate hike expectations. With the discounter likely to move higher in the coming months, investors should favor yield curve trades that are short that portion of the curve. With that in mind, we close our 2-year over 1-year/5-year trade and initiate a position short the 7-year bullet and long a duration-matched 2-year/30-year barbell. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1 We don’t expect to see sustained yield curve inversion until late this year. For further details please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “Buy Corporate Credit”, dated January 15, 2019, available at usbs.bcaresearch.com 3 For further details on the models please see U.S. Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Corporates: The same indicators that called the early-2016 peak in credit spreads are once again sending a positive signal. Investors should tactically increase exposure to corporate bonds at the expense of Treasuries. Duration: Treasury yields will rise in the coming months as credit spreads tighten and financial conditions ease. Maintain below-benchmark portfolio duration. TIPS: The 10-year TIPS breakeven inflation rate has fallen too far, and it is now well below the fair value reading from our Adaptive Expectations model. Remain overweight TIPS versus nominal Treasury securities. Feature We continue to view the 2015/16 episode as the appropriate comparable for current market behavior, and the same indicators that called the early-2016 peak in credit spreads are once again sending a positive signal. As such, we recommend increasing portfolio allocations to both investment grade and high-yield corporate bonds at the expense of Treasury securities (see the Recommended Portfolio Specification Table on the last page of this report). Importantly, our cyclical view of the credit cycle has not changed. Elevated corporate debt balances and a relatively flat yield curve suggest that we are in the awkward middle phase of the cycle when excess returns from corporate credit tend to be positive, but low.1  However, recent spread widening has been excessive for this middle phase of the cycle, and we expect spreads to tighten from oversold levels during the next few months. Three Reasons To Upgrade Credit (& One Key Risk) Reason 1: Elevated Spreads The first reason to upgrade corporate credit is the attractive entry point (Chart 1). Outside of the Aaa space, 12-month breakeven spreads for every credit tier (encompassing both investment grade and junk) are above their respective historical medians. For example, the 12-month breakeven spread for the Baa credit tier is at 59%. This means that the spread has been tighter than its current level 59% of the time since 1988 and wider than its current level 41% of the time. Historically, spreads tend to hover within the tight-end of their historical range during this middle phase of the credit cycle, and only cheapen significantly when the yield curve inverts and the default rate moves higher. Chart 1Corporate Bonds: Attractive Entry Point Corporate Bonds: Attractive Entry Point Corporate Bonds: Attractive Entry Point Reason 2: Fed Capitulation The 2015/16 roadmap is applicable to the current market because in both cases credit spread widening was driven by the combination of weaker global growth and relatively hawkish Fed policy.2 With that in mind, an important pre-condition for spread tightening is a shift in the market’s expectations for Fed policy. Investor psyche must change from viewing monetary policy as restrictive to viewing it as accommodative. Chart 2 shows the three indicators we’ve been monitoring to signal when this shift occurs. All three called the early-2016 peak in credit spreads, and all are sending a strong buy signal at the moment. Chart 2Fed Capitulation Indicators Send A Strong Signal... Fed Capitulation Indicators Send A Strong Signal... Fed Capitulation Indicators Send A Strong Signal... Our 12-month Fed Funds Discounter, the change in the fed funds rate that is priced into the overnight index swap curve for the next 12 months, has collapsed from an early-November peak of 66 bps all the way to -4 bps (Chart 2, top panel). The gold price has also rebounded smartly (Chart 2, panel 2). Gold tends to rally when the market perceives that monetary policy is becoming more accommodative because the increased risk of future inflation makes gold’s “store of value” characteristics more appealing.3 Finally, the trade-weighted dollar has started to depreciate (Chart 2, bottom panel). This signals that U.S. monetary policy is easing relative to the rest of the world, and is historically correlated with stronger global growth. Reason 3: Imminent Global Growth Rebound The high-frequency global growth indicators that called the early-2016 peak in credit spreads are not sending as strong a signal as the monetary policy indicators, but there has been some positive movement (Chart 3). Chart 3...While There Is Positive Movement In Global Growth Indicators ...While There Is Positive Movement In Global Growth Indicators ...While There Is Positive Movement In Global Growth Indicators The CRB Raw Industrials index has only flattened-off in recent weeks (Chart 3, top panel), but the Market-Based China Growth Indicator created by our China Investment Strategy team has been rising quickly (Chart 3, panel 2).4  Finally, the price of global industrial mining stocks is no longer in free-fall. Rather, it is showing some signs of stabilization (Chart 3, bottom panel). Of the six indicators shown in Charts 2 and 3, four are sending strong buy signals and the other two are more or less neutral. In sum, we think this is enough of a signal to upgrade exposure to corporate bonds. One Key Risk The key risk to our tactical upgrade is that there is no follow-through from Fed easing to stronger global growth. In 2016, Fed capitulation coincided with a ramp-up in Chinese stimulus efforts. Chart 4 shows that our China Investment Strategy team’s Li Keqiang Leading Indicator moved sharply higher in early 2016.5 Moreover, all six components of the indicator participated in the uptrend. At present, only some components of the Leading Index have rebounded and the overall index has merely leveled-off. Chart 4Chinese Growth Is The One Key Risk China Is The One Key Risk China Is The One Key Risk When it comes to Chinese growth, a trade deal with the U.S. would certainly help matters. However, the risk remains that Chinese policymakers continue to curb credit growth so much that the pass through from easier Fed policy to global growth is weaker than in 2016. Bottom Line: With Fed rate hikes priced out of the market and signs of stabilization in high-frequency global growth indicators, the toxic combination of tight Fed policy and weak global growth is disappearing. This should allow credit spreads to tighten from current oversold levels. The rapid shift in monetary policy expectations makes us think that spread tightening could occur over a relatively short timeframe. As such, we would recommend this upgrade only to tactical (3-6 month) investors. Those with longer investment horizons may be better served by waiting for spreads to tighten and then using that opportunity to reduce cyclical corporate bond exposure. A Note On Portfolio Duration As mentioned above, the market has completely priced out Fed rate hikes. At present, the overnight index swap curve discounts 4 bps of rate cuts over the next 12 months and 17 bps of rate cuts over the next 24 months. This shift in market rate expectations is the main reason for our rosier outlook on corporate spreads, but it’s important to remember that the causation between credit spreads and policy expectations runs both ways (Chart 5). Chart 5 It is the recent spread widening and sharp tightening in financial conditions that caused the Fed to adopt a more accommodative policy stance in the first place (Chart 6). In the background, the U.S. economic data remain robust. The New York Fed’s GDP Nowcast model projects above-trend real GDP growth of 2.5% in 2018 Q4 and 2.1% in 2019 Q1. The corollary is that once credit spreads tighten and financial conditions ease, the Fed will have no further reason to stay on hold. Chart 6Financial Conditions Likely Going To Ease Going Forward Financial Conditions Likely Going To Ease Going Forward Financial Conditions Likely Going To Ease Going Forward If financial conditions ease during the next few months, as we expect, then it is very likely that the Fed will be ready to lift rates again at the June FOMC meeting. The fed funds futures curve currently discounts less than a 20% chance of that happening.  Bottom Line: The U.S. economic data are solid. The sharp fall in rate hike expectations and Treasury yields is purely a reaction to tighter financial conditions. Treasury yields will rise in the coming months as credit spreads tighten and financial conditions ease. Maintain below-benchmark portfolio duration. Inflation & TIPS The main reason why the Fed feels comfortable responding to tighter financial conditions by adopting a more dovish policy stance is that inflation remains well contained. Last week’s CPI report showed that core CPI grew by 2.2% in 2018, somewhat below levels that are consistent with the Fed’s target (Chart 7).6 Chart 7Inflation Remains Well Contained Inflation Remains Well Contained Inflation Remains Well Contained Looking at the monthly changes, we also see that core CPI has increased by roughly 0.2% in each of the past three months. This translates to an annualized rate of approximately 2.4%, in line with the Fed’s target (Chart 8). The monthly changes shown in Chart 8 also reveal that the year-over-year growth rate in core CPI will almost certainly decline next month when the strong 0.35% print from last January falls out of the trailing 12-month sample. Chart 8Muted Inflationary Pressures For Now Muted Inflationary Pressures For Now Muted Inflationary Pressures For Now However, after next month base effects start to turn supportive. Our Base Effects Indicator, an indicator that compares rates of change in core CPI ranging from 1 to 11 months, predicts that year-over-year core CPI inflation will be higher six months from now (Chart 9). Chart 9Expect Higher Inflation Six Months From Now Expect Higher Inflation Six Months From Now Expect Higher Inflation Six Months From Now The conclusion is that inflationary pressures appear muted right now, and will continue to appear muted through the end of February. However, we expect them to ramp up again as we head into March. Come June, it is quite likely that the Fed will be feeling the pressure to lift rates as inflation approaches target. Coincident with a renewed uptick in inflation, TIPS breakeven inflation rates are also biased higher during the next six months. Slowing global growth and falling oil prices drove long-maturity breakevens lower during the past few months, with the result that the 10-year TIPS breakeven inflation rate is now 1.83%, 14 bps below the fair value reading from our Adaptive Expectations model (Chart 10).7  Chart 10Message From Our Adaptive Expectations Model Message From Our Adaptive Expectations Model Message From Our Adaptive Expectations Model Our Adaptive Expectations model contains three independent variables: The 10-year trailing rate of change in core CPI (Chart 10, panel 3) The 12-month trailing rate of change in headline CPI (Chart 10, panel 4) The New York Fed’s Underlying Inflation Gauge (Chart 10, bottom panel) Of those three variables, the 10-year trailing rate of change in core CPI carries the largest weight. This long-run measure of core inflation is currently running at an annualized pace of 1.83%. This translates roughly to an average monthly increase of 0.15%. In other words, as long as monthly core inflation prints above the 0.15% level, the fair value from our Adaptive Expectations model will continue to rise. Bottom Line: Core inflation has been steady during the past few months, but base effects will turn positive after next month’s report. This means that we will probably see higher year-over-year core CPI inflation in six months. With the 10-year TIPS breakeven inflation rate already well below the fair value reading from our Adaptive Expectations model, we expect TIPS will outperform nominal Treasuries during the next six months.   Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “An Oasis Of Prosperity?”, dated August 21, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “A Signal From Gold?”, dated May 1, 2018, available at usbs.bcaresearch.com 4 For further details on how this indicator is constructed please see China Investment Strategy Weekly Report, “Trade Is Not China’s Only Problem”, dated November 21, 2018, available at cis.bcaresearch.com 5 The Li Keqiang Leading Indicator is a composite indicator of money and credit growth measures designed to predict changes in the Li Keqiang Index (a coincident indicator of Chinese economic activity). For further details on how the Leading Index is constructed please see China Investment Strategy Special Report, “The Data Lab: Testing The Predictability Of China’s Business Cycle”, dated November 30, 2017, available at cis.bcaresearch.com 6 The Fed targets 2% PCE inflation. CPI inflation tends to run about 0.4%-0.5% higher than PCE, which means the Fed’s target is roughly 2.4%-2.5% for CPI. 7 For further details on the model please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Survey data are easing, but that should not come as a surprise: The economy should decelerate as fiscal thrust is dialed back. Just a little patience (yeah-eah): A chorus of Fed speakers have taken to the podiums to reassure the public that the FOMC is taking its concerns seriously. The labor force participation rate popped in December, but investors shouldn’t count on it to produce a Goldilocks dual-mandate outcome: The demographic obstacle to continued part-rate gains is formidable. It is too early to de-risk portfolios: We remain constructive on risk assets and the economy. Feature Walking past flat-screen TVs during the workday has become considerably more pleasant. CNBC has switched out its red-drenched Market Sell-Off backdrop for a bright-green backdrop framing cheerful messages like, “Stocks are on track to rise for the third day in four.” In the ten sessions following Christmas Eve, the S&P 500 gained a stout 10%. Even a sharply negative preannouncement from Apple, and the prospect that 8% of Amazon’s outstanding shares could eventually hit the market, failed to halt the upward march. Only the disappointing December ISM Manufacturing survey has managed to bother the equity market over the course of the snapback rally, but the disappointment was quickly forgotten upon the next morning’s release of the gangbusters December employment report. The down-2.5%-one-day-up-3.5%-the-next action highlighted the fragility of the investor psyche. Markets are deeply uncertain about the economy, and how the Fed’s rate-hiking campaign will impact it. This week, we consider the evidence from the ISM and NFIB surveys, the recent wave of comments from Jay Powell and the regional Fed presidents, and the labor market to reassess our outlook for financial markets and the economy. Survey Says Over the first two weeks of January, the ISM surveys, the NFIB small business survey and the Job Openings and Labor Turnover Survey (JOLTS) all indicated slowing in their subject areas. An investor could point to them as evidence that the expansion is on its last legs, but we interpreted them as mixed, and do not see them as an argument for de-risking portfolios. Recall that the economy grew so far above trend in 2018 because of a generous helping of fiscal stimulus; as the stimulus is throttled back, the economy will decelerate. Markets had already factored the survey results into their expectations and took them in stride (Chart 1). Chart 1Soft Data Are Not A Surprise Soft Data Are Not A Surprise Soft Data Are Not A Surprise The magnitude of the weakness in the manufacturing ISM survey did come as a surprise. Beneath the headline (Chart 2, top panel), the employment reading slipped (Chart 2, second panel) and prices paid plunged (Chart 2, third panel), suggesting that the economy may not be so robust after all, but at least stagflation is not yet a concern. New orders, the component with the best leading properties, fell a whopping eleven points to get uncomfortably close to the boom/bust line (Chart 2, bottom panel). Chart 2Manufacturing May Be Wobbling, ... Manufacturing May Be Wobbling, ... Manufacturing May Be Wobbling, ... Manufacturing accounts for a modest share of U.S. employment and output, and we don’t dwell too much on it per se, but it may provide a window into global conditions. Trade tensions’ impact on global growth has been our foremost worry this year, and it is possible that the weakening manufacturing ISM points to weakness in the global economy. The U.S. is fairly inured from global weakness relative to other economies, but there is no such thing as decoupling. Weakness in the rest of the world will eventually make itself felt in the U.S., and we are watching the trade climate and global conditions carefully. The services ISM also declined more than expected, but a reading in the 57-58 range is strong, and points to an economy growing above trend. Employment (Chart 3, second panel) and new orders (Chart 3, bottom panel) both remain at or above a standard deviation above the mean. It is often true that markets care more about incremental changes than levels, but it is not an always-and-everywhere rule. In the context of an economy operating well above capacity, some slowing is both inevitable and desirable. We will watch the services ISM for signs of continued slowing, but we do not yet see any cause for concern. Chart 3... But Services Are Still Strong ... But Services Are Still Strong ... But Services Are Still Strong Small-business optimism continues to support a constructive take on the economy, despite the modest pullback in the NFIB survey and some of its key components. The headline index has come off of the all-time highs it set in 2018, but remains at very high levels relative to history (Chart 4, top panel). Job openings hit an all-time high in December (Chart 4, second panel), underscoring the message from the persistently strong payrolls data, and the share of small businesses deeming it a good time to expand (Chart 4, third panel) and that plan to expand headcount over the next three months (Chart 4, bottom panel) are well above one-standard-deviation levels. Surveys are soft data, but both the headline optimism index and the good-time-to-expand component have begun to slide well in advance of the last three recessions, suggesting they’re useful leading indicators. Chart 4Small-Businesses Are Still Bulled Up Small-Businesses Are Still Bulled Up Small-Businesses Are Still Bulled Up As strong as the employment picture has been, it is only a coincident indicator. The dot-com recession took employers (Chart 5, top panel) and job-hopping employees (Chart 5, bottom panel) by surprise, but there is nothing in the rate of job openings or quits in the JOLTS (Job Openings and Labor Turnover Survey) data that should inspire concern about the state of the economy. The series are off their highs, but there’s nothing to worry about at their still-elevated levels. Chart 5Softer, But Hardly Soft Softer, But Hardly Soft Softer, But Hardly Soft Bottom Line: Survey data have weakened as fiscal stimulus has waned, just as investors should have expected. We are keeping a close eye on the new orders component of the ISM Manufacturing survey, but nothing in the services ISM, NFIB or JOLTS surveys merits too much concern. FOMC Members Speak (And Speak, And Speak) The New Year brought an avalanche of comments from FOMC members. Chairman Powell, Vice Chairman Clarida, and seven regional presidents gave speeches, made appearances, or sat for interviews in the first two weeks of January, and New York Fed president Williams gave a long interview to CNBC two days after the December meeting. Away from uber-dove Bullard (St. Louis), who warned in a Wall Street Journal interview that further rate hikes could tip the economy into a recession, the various officials stressed the Fed’s open-mindedness. (Bullard, who is an FOMC voter this year, has repeatedly urged caution about hiking too much.) The overall thrust of the remarks has been to accentuate the FOMC’s commitment to go where the data lead. Echoing the language in the December minutes, several speakers noted that the Fed can be “patient,” given that inflation shows no signs of breaking out. The impact has been to soothe markets, which seem to be acutely concerned that rate hikes might go too far. (Though the speakers did little to ease concerns about balance-sheet reduction, or “quantitative tightening,” the Treasury, corporate-bond, and equity markets retraced much of their risk-off moves anyway.) Jay Powell set the tone for the overall message in a public appearance on January 4th, when he said the Fed “was listening sensitively to the message the markets are sending.” He underlined the data-dependency theme in an appearance last week, in which he said that, “we can be patient and flexible and wait and see what does evolve, and I think for the meantime, we’re waiting and watching. You should anticipate that we’re going to be patient and watching, and waiting and seeing.” His FOMC colleagues took care to drive home the same talking points, noting that data dependency includes following sentiment surveys, talking with business contacts, and watching markets. The speakers and the minutes also highlighted the discrepancy between robust 2018 growth of at least 3% and the much gloomier outlook implied by financial markets’ dreadful fourth quarter. None of the sensitive listeners disregarded the markets’ concerns, though Boston president Rosengren suggested that the markets may have gotten carried away. “My own view is that the economic outlook is actually brighter than the outlook one might infer from recent financial market movements.” Although we think the Fed will hike several more times before reaching this cycle’s terminal fed funds rate, the uniformity of the FOMC member comments leads us to expect that it will take a break, perhaps until June. Bottom Line: Our terminal fed funds rate estimate remains considerably higher than the money market’s, but we expect the Fed will pause for a few meetings. A pause may soothe markets and unwind the tightening of financial conditions that occurred in the fourth quarter, clearing the way for the Fed to resume its tightening campaign. Labor-Market Goldilocks The December employment report pointed the way to an outcome that could satisfy financial markets and FOMC doves like Minneapolis president Kashkari. Despite the outsize expansion in nonfarm payrolls, the unemployment rate rose by two ticks because of a surge in labor force participation. Last week, Kashkari attributed his ongoing aversion to rate hikes to the possibility that there’s more slack in the labor market than the committee may realize. “There might be a lot more people out there that we just don’t know [about] that are uncounted. Let’s go figure that out, and if we see inflationary pressures building, we can always hike rates then.” If the participation rate rises at a pace that allows new labor supply to offset continuing demand for workers, expanding payrolls don’t have to exert any generalized upward pressure on wages. Absent upward wage pressure, inflation could easily remain well-behaved. One month doesn’t make a trend, but December’s 63.1% reading brought the part rate back to the top of the range that has been in place for five years (Chart 6). A breakout could point the way to a Goldilocks outcome of inflation-free employment gains, but demographics suggest that there’s a limit to how much the part rate can advance. Chart 6Back To The Top Of The Range Back To The Top Of The Range Back To The Top Of The Range The demographic drag on participation is largely a function of the baby boomers’ extended departure from the work force. AARP estimates that at least 10,000 of them turn 65 every day, and will continue to do so into the 2030s. Boomer employment was in its heyday in the late ‘90s, when potential participation exceeded 67% (Chart 7, top panel), and all of the baby boomers were in their prime working years.1 Now that they are exiting the labor force in a lengthy procession, labor force participation is swimming upstream, and it may not be able to do much more than hold the level it’s maintained since 2014. Chart 7How Much More Slack? How Much More Slack? How Much More Slack? The shrinking supply of discouraged workers (workers who would start a job tomorrow if they were offered one, but are no longer actively looking for work and are therefore not counted as unemployed), suggests that much of the slack in the labor market has already been consumed (Chart 7, bottom panel). The disability rolls could be a source of Kashkari’s “uncounted” potential workers, however. The share of idled workers receiving disability benefits rose after the crisis (Chart 8), accounting for some of the widening gap between the part rate and the demographically-adjusted part rate. It is possible that some people who weren’t truly disabled will be motivated to come back to work, and their return to the work force may account for some of the pickup in participation, but our best guess is that they represent no more than a marginal source of labor supply. Chart 8Disability Claimants Won't Save The Day Disability Claimants Won't Save The Day Disability Claimants Won't Save The Day Bottom Line: The available evidence suggests that the labor market is quite tight. We expect that upward wage pressures will become increasingly apparent across 2019. Investment Implications An increasingly conciliatory Fed offers additional support for our equity overweight. A Fed pause might relieve some upward pressure on interest rates, but we expect that relief will only be temporary. As financial markets heal, easier financial conditions will clear the way for the Fed to resume its rate-hiking campaign. The sharp decline in Treasury yields at longer maturities only increases our conviction in underweighting Treasuries and maintaining below-benchmark duration positioning in all bond portfolios. As we noted last week, we think the high-yield bond market overreacted last quarter. Against a benign default outlook for 2019, 200 basis points of spread-widening seems extreme. A spread-product upgrade would fit with our equity upgrade, but we will wait until our U.S. Bond Strategy colleagues complete their review of their own recommendation before we consider changing our call. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com   Footnotes 1 Workers between the ages of 25 and 54, inclusive, are considered to be in their prime working years. The boomers were born between 1946 and 1964, and they were all in their prime working years from 1989 (when the youngest cohort turned 25) to 2000 (when the oldest cohort turned 54). 2018 was the last year that any of the boomers were between 25 and 54.